An Index-Contingent Trading Mechanism: Economic Implications

Posted: 23 Jul 1999

See all articles by Avi Wohl

Avi Wohl

Tel Aviv University - Coller School of Management

Shmuel Kandel (deceased)

Deceased

Abstract

In many stock exchanges around the world "batch" or "clearing" is used as a method of trading. Currently, an essential problem in the application of this trading mechanism is that orders in one security cannot be conditioned on prices of other securities. In this paper we propose to move one step in the direction of cross-conditioning and to facilitate conditioning on an index (a weighted average of the stock prices) that is simultaneously determined with the prices of all assets. The economic implications of this trading mechanism are analyzed in the framework of rational expectations equilibrium models and certain empirical implications are derived. We show that an index-contingent trading mechanism may contribute to the efficiency of prices and to the reduction of losses and risks sustained by noise traders. In particular, we compare two trading systems, with and without index-conditioning, and find that in the system with index-conditioning (i) price fluctuations around "true" values are lower, (ii) expected losses of "noise traders" are lower, (iii) the variance of the payoffs to the "noise traders" is lower,(iv) the expected utility of informed traders is lower, and (v) the expected volume of trade is higher than in a model without cross-conditioning.

JEL Classification: G12

Suggested Citation

Wohl, Avi and Kandel (deceased), Shmuel, An Index-Contingent Trading Mechanism: Economic Implications. Available at SSRN: https://ssrn.com/abstract=5310

Avi Wohl (Contact Author)

Tel Aviv University - Coller School of Management ( email )

P.O. Box 39010
Ramat Aviv, Tel Aviv, 69978
Israel
+972 3 6409051 (Phone)

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